The Rise of Cryptocurrencies

More and more investors are asking me about Bitcoin. And Litecoin. And Ethereum. And a myriad of other new kinds of “digital money” that have entered the global financial market in the last few years. The conversation typically goes something like “Scott, I’m hearing more and more about bitcoin and am hoping you can tell me if I need to understand it, invest in it, or just chalk it up as a 21st century unicorn?”

It reminds me of a conversation I had with my sons about 12 years ago. At the time, they were in high school and were trying to explain to me this trendy exclusive networking website that college students were using and high school kids were trying to gain access to but couldn’t without a college email address. I thought at the time it was just a cute way for kids to exert their independence and create their own space, as I couldn’t come up with any financial model I had studied in b-school that would enable it to make a profit. Anyone heard of Facebook?

Cryptocurrencies cannot be ignored.

With rising global financial and geopolitical uncertainty, escalating global currency disorders, and increasing distrust of governments around the world, I believe that the cryptocurrency market will continue to evolve. As investors and consumers we should understand these digital currencies, the inherent risks associated with them and how they may affect our financial future.

What is this thing called bitcoin?

Right now bitcoin is the most popular of hundreds of cryptocurrencies—sometimes referred to as crypto money or crypto assets. Think of it as a form of digital money. Or virtual currency. Or a virtual commodity.

Bitcoins are essentially a sequence of encrypted “bits” transmitted over a network by a process called cryptography. Hence the names bitcoin and cryptocurrency. And just like we have multiple fiat currencies like the US dollar, the British pound or the Chinese Yuan, we now have multiple cryptocurrencies like bitcoin, litecoin, and ethereum. And bitcoin to cryptocurrencies is like the US dollar to fiat currencies. It’s the reserve currency of the crypto-world.

What’s the point of creating this cyber money?

Bitcoin was created in 2009 by a mysterious developer named Satoshi Nakmoto as an electronic payment system devoid of any central authority or high transaction fees. The most important point is that it is completely DECENTRALIZED unlike centralized banking and economic systems such as the Federal Reserve System and other central banks around the world.

Alexander Hamilton (who led the fight to establish the first central bank in the US) is probably rolling over in his grave.

I can guarantee you that if we were eavesdropping on conversations behind closed doors, central banks and governments and others who tout centralization as the linchpin of monetary policy are all taking this cyber-phenomenon very seriously and are scrambling to figure out what to do, how to regulate, how to control, how to tax, and how to stop uncontrolled movement of it across borders. It is becoming a head-on challenge to central banks’ historical control and influence over the monetary systems and policies around the world.

What is the technology powering it?

All bitcoin transactions are kept track of in something called “blockchain”–a technology that is like one big transaction log/ledger where all involved in a transaction can see all the other transactions in the network. It’s a peer-to-peer network keeping a consensus about accounts and balances, but the actual identities of the people making the transactions are anonymous. The ‘gatekeepers’ that keep track and verify everything are called miners and they use computer power from all over the world to run these self-contained cryptocurrency systems.

While it is hard for me to see the intrinsic value in bitcoin as money for the future, I do see the value of the technology platform. So do major tech companies like Microsoft and Amazon–they are making significant investments in blockchain technology. Some believe it could be the future for financial transactions, so you know that venture capital firms and others will find avenues to invest in this market if there is value in its technology.

What does it take to get Bitcoin?

The easiest way now to get them is to buy them. But first you get an electronic “wallet”— either on your mobile device or your desktop. But buyer beware! Countries differ on the legality of cryptocurrencies. In Japan—the use of this “currency” is legal. But in Bangladesh, you go to jail. As of 2014 in the US, the I.R.S. said it would treat all virtual currencies as “property” not currency.

There are bitcoin exchanges where you can purchase the virtual currency, and some are buying it for investment purposes rather than a means of paying for goods and services. But because it is still in its development phase and doesn’t have a long track record or credibility, it is a very high-risk investment to make.

What could happen?

Forbes recently wrote a good piece on the future of bitcoin. It noted that while we are far off from any government declaring it a preferred form of currency, we are already seeing some places accepting it as an alternative means of payment.

But will it become a widely accepted method of payment or an alternative investment to other asset classes?

Enthusiasts hope so, but many economists say no way.

The issue with all surrogate currencies that have tried to replace accepted currencies is that they are not backed by anything other than the market determination of their value. There is no intrinsic value in them. There is no government declaring their value. And, digital currencies are not a commodity (like gold) that has stood the test of time and proven to be a solid investment.

What are the risks?

Regulators all around the world will figure out how to regulate this market. They have no other option because as a competitor to a government currency, the cryptocurrencies can be used on the black market for illegal activities and tax evasion. As governments and regulatory bodies scramble to enact rules, there will be varying laws and regulations that without clear global uniformity (which will be impossible to attain in this era of political instability and unrest) will significantly challenge the longevity and liquidity of this asset class. Any government could ban the use of or restrict the sale of these crypto assets at any time.

Further, bitcoin exchanges and, in fact, the entire cryptocurrency market, is digital, and at significant risk of hackers, scammers, malware and meltdowns like we have seen in recent years with other seemingly impenetrable systems getting hacked or shutdown, operationally paralyzing companies and citizens around the globe. This actually happened to the cryptomarket several years ago in Japan when a Bitcoin exchange (Mt. Gox) got hacked and had to close down after millions of dollars worth of bitcoin were stolen.

And, of course, important to investors, bitcoin cannot be included in any tax-advantaged retirement accounts nor are they insured by any federal or government program like your bank account is with the FDIC.

What should you do?

Security and stability around our investments and our currencies, whether it’s fiat or crypto is important and savvy investors make every effort to stay diversified to keep their purchasing power strong and at less risk for being significantly devalued.

So we need to be making very smart decisions about our portfolios.

We are early in the crypto game and it is highly speculative to think that it will become the next form of money or that it will be a sustainable and strong investment.

I do know is that gold has been around longer than all other forms of money. From cows to cash to credit cards and now potentially crypto, the one constant throughout the history of money, is gold.

I am going to keep investing in a physical commodity that is mined and minted in reality, not just virtually. And by reputable companies and government mints, not by a group of “people” whose identities are mysterious.

I am not going to jump on the bitcoin bandwagon. At least not until some of the significant risks and uncertainties play out and there are signs of stability, longevity, uniformity and liquidity.

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